If they are more expensive then what they are now, don’t worry. This is just an exercise; start it off with how you’d like it to be.

Expenses

Think about the categories that you might have in the future that you probably aren’t accounting for today.

I can think of one big one: Health care. If you aren’t paying for your medical expenses right now because your employer is covering them, then that will probably change. Whether or not Medicare exists in the future by the time you are able to retire early, there will more than likely be something similar to it. So for planning purposes, feel free to work it into your numbers.

What about extra money for travel? Now that you’re financially free, you’re probably going to want to get out there and see the world. And your pocketbook shouldn’t hold you back from doing so!

Also, feel free to add in any extra new expenses you foresee. For example: If you always wanted to take up golf or learn to cook, those will both be great hobbies to learn. But they will not be free!

Do you have some sort of an idea of a monthly / annual figure?

Great! But we’ve got further to go.

Deductions

Now we’re going to take some money off of that number you just figured out, starting with taxes.

Taxes. We haven’t worked taxes (Federal or State) into our equations yet, and those will definitely need to be considered.

But here’s the good news: There’s a good chance that if you’re planning to retire early and live off of less money than what you earn right now, you’ll more than likely enjoy a lower effective tax rate.

Just so you know, when someone says you’re in the 25% tax bracket, you don’t calculate your taxes by simply multiplying your income by 25%. The U.S. tax system calculates your taxes using something called a “marginal tax bracket system”. You can see a good example of how that works at this link here.

All you have to do is take your desired annual income number, subtract away your standard deduction, a personal exemption for you and your spouse, (you can find both of those numbers here) and then you’re left with your taxable income level.

Don’t worry! It’s not too hard to estimate them. But it is important that you do it the proper way.

(By the way, how would you like to pay zero taxes in retirement? Here’s a post I wrote detailing how to pull this off.)

Pensions. Next, you can deduct away any pensions or other guaranteed income from your annual desired income amount. Unfortunately for most people, unless you work for the state or a union that still offers them, this one won’t apply.

Social Security. Despite what you may think, you are entitled to receive Social Security payments in the future if you have been paying into the system and meet their qualifications. Go over to Social Security’s website and try out their free calculator to find out how much you and your spouse will qualify for.

Be mindful that after the year 2034, they only have enough funds to pay out 79 cents for every dollar you’re entitled to. Even at this fraction, your Social Security income will be an important part of your overall retirement plan.

Please don’t quite subtract this value from your annual total yet. Later on, I’ll have some different and creative ways we can incorporate them into our strategy.

Imagine it’s your first day of never having to work again. You’ve waited a very long time for this day! So now that it’s here, what are you going to do today?

Are you going to get some stuff done around the house?

Maybe you’re going to play golf, or do that other hobby you like to do.

Maybe you’ll finally relax!

Now imagine a week has gone by. How many times have you:

Ventured out?

Gone out to lunch?

Been to the store?

Made purchases?

Visited family or friends?

Now imagine it’s been a year. How many:

Trips have you planned?

Places have you traveled?

Projects have you started?

Groups have you joined?

Other things you’ve done to keep yourself busy and occupied?

Now for the not-so-fun stuff. How many times have you:

Been to the doctor?

Been to the dentist?

Been to the hospital?

Filled prescriptions?

Had an x-ray?

Had a surgery?

What about the number of times:

The car had a problem and needed to be repaired.

Something in the house stopped working.

You had to get a new washing machine or refrigerator.

You needed a new roof or had to fix a foundation crack.

You had to handle some unexpected emergency.

Is your fixed income starting to feel a little constricting?

Being Realistic About Your Needs

Why am I asking you go through this mental exploration of ups and downs?

Because of this reason: It’s critical that your entire financial freedom plan is based on realistic numbers that you believe in; not just numbers you think you can live with.

Make sure you understand the difference between the two. I read blogs all the time where people seem to try to talk themselves into thinking that they can retire comfortably on some small amount of savings and will be happy living near poverty. Why? To me, it seems, they are more fixated on achieving the goal of early retirement rather than understanding what the goal means.

Your retirement plan needs to be based on your spending habits and your lifestyle. It has to be reflective of the way that you want to live. People who have achieved financial independence stay that way because their plan was built to suit their goals rather than only to reach some arbitrary number.

Depending on how much work you’ve already put into this topic, this mental exploration may also help you gain a better understanding of what retired life will be like.

For some people, you may have realized that your life in the future may require more money than you thought. But for other people, they may be surprised to find out that it could require less.

A Starting Point: 80%

Confused about where to take your first step towards gauging your retirement income?

Don’t be. Financial research has shown that, on average, most people tend to live on roughly 80% of their pre-retirement income.

Why 80%? Because that’s actually about how much you already live off of right now. Here’s how they come up with that figure:

Start off with 100% of your gross household pay.

Subtract away 10% for your 401(k) contributions (if that’s how much you contribute) since you won’t be contributing to a 401(k) when you’re retired.

Subtract away another 7.65% for your FICA (Social Security and Medicare) taxes since you will no longer be paying those either once you’re retired.

Finally, subtract away another 5 to 10% since you will cease to have a lot of the same work expenses such as commuting, new clothes, dry cleaning, eating out at lunch, after work drinks, etc.

Remember: 80% is just another general, average recommendation to give you a place to start.

Do you have an annuity? You may not know this, but it is possible to sell annuity payment for cash right now to use how you best want for your retirement. Since interest rates are still low and they aren’t about to go up anytime soon, in order to get the most money for your retirement, you might be better off investing it yourself.

To get a better idea of what will fit your specific needs, you’ll need to create an estimated future budget … and we’re going to do that right now!

One of my favorite quotes on this topic comes from author Charles Farrell in his book “Your Money Ratios”:

All decisions you make should help move you from being a laborer to being a capitalist. All of us are laborers. But as a capitalist, you are not paid for the value of your labor, but for the use of your money.

In other words, you could think of financial freedom is being the point at which you transition from someone who needs to work for money to being someone who’s money works for them. Rather than going to work every day and getting a paycheck, all of the money you’ll ever need will come from the assets you’ve spent your life accumulating.

So how does this work? How exactly does one become a “capitalist”?

The Retirement Equation

This may shock you, but at its core, retirement planning really simple. It really only comes down to three very important elements:

How much income you desire each year when you’re retired.

The withdrawal rate or percentage of your money that you can reliably take out of your nest egg savings each year.

The size of the nest egg (the summation of all your savings for retirement).

Putting these three variables together, they relate to one another like this:

Or, if you’re interesting in understanding how much you need to save in your nest egg, then you can re-write the equation as follows:

These three factors are like a triangle. They constrain one another. You can’t move one part without affecting the other two.

Example

According to the Census Bureau, the estimated real median household income in the U.S. was $54,462 in 2015. Because I like to use realistic numbers in my examples, we’re going to round this number down to $50,000 and use it as our target retirement income figure all throughout the book.

Of course, the equations are simple enough that you will be able to do the same thing with whatever number is better suited to fit your specific needs.

If we generically assumed we could withdraw 5% from our nest egg each year, then the target nest egg that we’d need to save up for would be:

$50,000 / 0.05 = $1,000,000

Is That All There Is To It?

Of course not!

[If it was, then this would be a very short book.]

The thing about retirement planning (and especially early retirement) is that it’s not the equation that’s hard, but the meaning behind the numbers that’s important!

I can’t stress this point enough, and so I’ll say it again.

Knowing what makes for “good” numbers is critical!

As we went through that simple example above, you probably had a lot of VERY good and completely valid questions:

Is $50,000 enough retirement income?

What if you need more?

What if you could be happy with less?

Is a withdrawal rate of 5% appropriate?

How long will it last?

Is it safe?

How do we know?

Where’s the data to prove it?

What sort of things do we have to invest in to make this all work?

What about inflation?

Is $1,000,000 a large enough nest egg?

What if you could enjoy the same amount of retirement income with a lower nest egg?

How much extra safety does saving more actually get me?

Is it even worth the extra trouble?

Will there be anything left to leave to my heirs?

… any many more!

That’s what the rest of this book is going to cover. We’re going to explore each of these questions more thoroughly and really try to gain a better understanding of what numbers to use for each of these variables.